In Connecticut, Has Risk Management Gone Awry?

Connecticut has always been known as the Land of Steady Habits. Last week, however, it also became known as the Land of Miserably Unhappy Commuters.

That’s because the high voltage feeder cable that powers the New Haven (Connecticut) to Grand Central Terminal (New York City) commuter train line failed last week. Stranded passengers were told to expect little or no train service for up to three weeks.

So why is this a prime example of risk management gone awry? It appears that the Metro-North rail system has always maintained a secondary electrical system. But two weeks before the failure, engineers removed the secondary system from service for maintenance upgrade work without replacing it with any other temporary resource. Thus, when the primary feeder cable failed last week, there was no other system in place to power the train line.

Regrettably, Connecticut Governor Dan Malloy noted that Metro North officials appeared to have been taken by complete surprise. He said that “there appears to have been little plan(ning) for this type of catastrophic failure.”

The discipline of Enterprise Risk Management (ERM) embraces a few key principles. Organizations must identify potential crises before they occur. For crises that are relatively likely to occur, preventive controls must be implemented to reduce the likelihoods. And for events that will be relatively costly if they occur, crisis response functions must be implemented to contain the costs of failure.

Did the folks at Metro North follow these principles? Because a failure of the primary feeder cable could inflict so much damage on commuters, one may question whether the secondary system should ever have been removed without the temporary implementation of another crisis response function. And because the severe aging of the electrical fleet and infrastructure makes such failures relatively likely to occur, one may ask whether the primary system (as well as, or perhaps in place of, the secondary system) should have served as the focus of preventive maintenance work.

In other words, Governor Malloy’s own observations reveal that the public transportation agency was following a risk management plan that was bound to go awry. And now the commuters of Connecticut are bearing the brunt of that failure.

Libor Manipulation: Calculating Damages

Last week, in our blog posting entitled Libor and the Public Interest, we discussed what National Public Radio has called the biggest scandal in the world. Of course, NPR was referring to the Libor manipulation scandal, a scheme that dwarfs the other controversies that are now roiling the financial services industry.

And we don’t use the word “dwarfs” lightly. After all, within the past week, we learned that traders at JP Morgan Chase may have hidden losses from CEO Jamie Dimon that are now expected to exceed $7 billion. We also discovered that HSBC laundered several billion dollars for Mexican drug cartels. And we were told that the bankrupt Peregrine Financial Group misappropriated over $200 million in client investments.

Nevertheless, what of the news that over a dozen global banks have been manipulating the Libor rate that continues to be used around the world to establish interest charges on variable loans? It affects every citizen who holds a variable mortgage, credit card, line of credit, or small business loan. It also affects billions of dollars of corporate debt instruments, issued by global corporations, that utilize the Libor rate to calculate interest charges.

Extent of the Profits

By how much did the banks profit during this scandal? Well, a single bank with a $10 billion debt position (or portfolio) that successfully moves the daily interest rate 0.1% in a favorable direction could earn an incremental $10 million that day. If ten of the sixteen banks that define Libor earn similar profits on that day, the colluding group could earn a collective $100 million.

And what if the same group repeats the tactic one hundred times in a year? The annual collective profit of the group would equal $10 billion. And the counter parties on the “flip sides” of those transactions, i.e. individuals and organizations that are unfavorably influenced by such moves in the daily interest rate, would thus lose $10 billion per year.

As a point of comparison, the entire Centers for Disease Control and Prevention of the United States — the government entity that protects the American public against maladies from HIV / AIDS to influenza epidemics — received $10.6 billion in total funding last year (i.e. in fiscal 2011). It’s no wonder that Time Magazine has suggested that the Libor scandal may be considered the crime of the century because of its immense scale.

Proving Damages

With profits that are so significant, and with commensurate losses incurred by others, one would think that it should be easy for aggrieved parties to sue the banks and collect damages. Surprisingly, though, plaintiffs would be advised to proceed cautiously before filing lawsuits.

After all, the Libor mechanism serves to summarize the interest rates that each global bank estimates it would pay if it borrows funds from other banks in the City of London. Yes, Libor focuses on estimates that each bank would pay as opposed to the precise rate that each actually pays, and the hypothetical interest percentage if each bank chooses to borrow, as opposed to the real amount when each bank actually borrows.

In other words, each bank’s daily Libor quotation represents an educated guess, as opposed to an actual report. In order for a plaintiff to estimate damages, though, he would need to calculate the interest rate that each bank would have quoted if it had no incentive to manipulate the rate. But if the Libor quotations only represent rough estimates and educated guesses, how can any plaintiff establish what an unbiased “actual” rate would have been for a particular bank on a certain day?

The Trouble With Proxies

There are always “proxies” available for any statistic, including (perhaps) credit default swaps for unbiased Libor rate quotations. According to a Connecticut government report, “a CDS is a privately negotiated derivative through which a “buyer” pays an agreed-upon amount to a “seller” and, in return, receives a payment if a certain event occurs … the buyer does not need to own the underlying security and does not have to suffer a loss from the event in order to receive payment …”

When independent investors believe that a global bank is more likely to default on its borrowings, they bid up the market price of the CDS that is designed to pay off in the event of a bank default. And because such a bank might expect to pay a higher risk-adjusted interest rate on its borrowings, some commentators believe that plaintiff attorneys can use fluctuations in CDS values as proxies for appropriate Libor estimates.

What is worrisome about this belief? Simply put, the CDS market itself is prone to manipulation by wealthy investors. A single large investor can drive up the value of a single CDS, at least temporarily, by making a large strategically timed purchase. So by using CDS values as proxies for Libor values, a plaintiff’s attorney would simply be substituting one manipulable statistic for another.

Clearly, it will not be easy for plaintiff attorneys to calculate damages. And without such calculations, it will be difficult for courts to require banks to pay awards.

Health Systems and the Public Interest, Part I

Have you ever wondered why America’s national military academy for Army cadets is located in West Point, New York?

Why not West Point, you might ask? If you ever visited the institution or strolled the streets of the adjacent town of Highland Falls, you undoubtedly noticed that the surrounding hilltop vistas of the lower Hudson Valley are breathtakingly beautiful. In fact, Army instructors such as Robert Weir have become globally renowned artists by painting landscapes of the Hudson River from the grounds of the academy.

Nevertheless, that’s exactly why West Point might strike you as an odd choice for the establishment of a military institution, particularly one focused on education in the science of warfare. Most military training centers, such as the historic Fort Dix in New Jersey and Fort Bragg in North Carolina, were designed to serve as free-standing and relatively isolated facilities. Few civilians have trekked to them to enjoy the natural scenery, and few of them have been concerned about the temptations of nearby municipalities. West Point cadets, on the other hand, are a mere 45 miles from New York City; commuter buses make the trip on a daily basis.

So why West Point? Well, it’s always been there, for a single reason that was once of utmost importance to the nation, but that is now a complete anachronism. And the reason for its continued presence in the Hudson Highlands tells us something about the cause of the inertia in today’s health system.

A Little Military History

Although it was President Thomas Jefferson who officially designated the West Point military facility as a center for education, its origins can be traced back to the American Revolution. At the time, with the British in firm control of New York City and Ontario, Canada, the leaders of the rebellion were greatly concerned that the redcoats would seize control of the entire Hudson River and thus isolate the New England colonists from their southern allies. They feared that the nascent nation could never stand on its own if it was literally split in two pieces by a hostile foreign military force.

So they decided to fortify a string of military installations throughout the Hudson Valley. North of Albany, they seized Fort Ticonderoga and won the Battle of Saratoga. And, on the western shore of a point of the Hudson River where a 150 ton chain could literally be stretched across the waterway to block traffic, they built a fortress.

This is why our nation’s oldest continuously occupied military installation was initially established in West Point: the British Army occupied New York City over 200 years ago, and the fledgling American army needed to stretch a gigantic chain across the Hudson River at that very geographic spot to prevent their advance. But Albany is no longer under any threat of invasion by British frigates, and military technology has advanced far beyond the use of gigantic chains; thus, these reasons are now interesting but obsolete relics of a distant past.

So why have we maintained our national military academy at West Point? Why not move it to a more modern, more cost efficient, and more geographically convenient location? And why not convert West Point to historical parkland, open for the enjoyment of landscape artists, hillside hikers,  and military historians alike?

Why not? The simple answer is inertia … and that may well be in the public interest. Once our national military academy was established at West Point, it put down roots and attached itself to the local landscape. Over time, it seared itself into the heart and soul of our nation as well. A decision by the military academy to vacate West Point would be as startling as the recent decision by General Electric to stop producing light bulbs in the United States, or the infamous decision by baseball’s Dodgers to leave its ancestral Brooklyn home.

The Public Interest

As you probably know, though, only a handful of American citizens are aware of the iconic firm’s decision to close its light bulb manufacturing operations. And although the Dodgers’ departure for Los Angeles left indelible scars on the psyches of native Brooklynites, it did help transform the sport into a truly national pastime, and helped drive our nation’s western expansion. Furthermore, many Brooklyn Dodger fans easily transferred their allegiances to the newborn Amazin’ Mets a few years after Dem Bums headed for California.

So why did GE’s decision barely cause a ripple in American society? Why did the Dodgers’ decision cause so much more anguish? And why would a similar decision by the United States Army to vacate West Point cause such unfathomable pain that it cannot even be seriously debated?

Why? Because we want government to run or regulate organizations that produce some public benefit, and such oversight usually leads to institutional inertia. GE easily ended its light bulb manufacturing activities, for example, because the American public was easily served by other service providers. But the Brooklyn Dodgers, despite being a privately run organization, were marketed as a civic institution; furthermore, they only departed after engaging in serious negotiations with New York government officials for years about moving to a publicly owned ballpark. And the President of the United States is the Commander In Chief of the American military forces, which are wholly owned and controlled by the federal government.

This insight helps us understand the raucous debate involving America’s health care system. If there is one issue on which all sides agree on, it is the fact that the public interest would be served by a system that offers an affordable set of services to all citizens. Nevertheless, it is this very consensus on the perceived public benefit of a comprehensive system that drives the desire for intensive government involvement. And furthermore, it is this very involvement that causes the institutional inertia that bedevils contemporary efforts at reform.

Next week: Health Systems, Part II